Econ homework -Opportunity Costs and Scarcity

Economic Models,

Tradeoffs and

Trade

1/10/19

1/15/19

Pre-Class Music In the End by Linkin Park

Agenda

• Key observations on economic issues in

Spain

• Key methodological issues in economics

• Production basics

• Tradeoffs in context of the production

possibilities frontier

• Comparative advantage and gains from

trade

Previously

• Economics is the study of how people

allocate their scarcity resources.

• “Scarcity” refers to the limited nature of society’s resources.

• Incentives are factors that motivate a

person to act or exert effort.

• Trade and markets can help in allocation

as can governments

Methods

The Scientific Method in Economics

• Best practice is to use the scientific

method to explain economic phenomena:

– Observe a phenomena

– Develop a hypothesis

– Construct a model to test the theory

– Design an experiment to test how well the

model works and collect data

– Revise or refute the theory based on evidence

Scientific Method in Action - 1

Scientific Method in Action - 1

OBSERVE AND DEVELOP HYPOTHESES

Scientific Method in Action - 2

Scientific Method in Action - 3

Positive and Normative Analysis

• Positive statement

– Can be tested and validated

– Describes “what is”

• Normative statement

– Describes “what ought to be,” hopefully based on criteria

– May be difficult test if an outcome is “best”

• Economists are concerned with both

positive and normative analysis.

What do you think?

• Is the statement positive or normative:

1. Rich people should be taxed more.

2. More taxes on the rich will increase tax

revenues.

3. Everyone should donate to charity.

4. Government intervention in markets is bad.

5. Economics majors earn more on average than

some other majors do.

Economic Models—1

• We use models to understand the complex

real-world economy.

• Models (sometimes called analytical

frameworks)

– In world of “theory” and “stories”

– Simplified versions of reality that capture the

essence

– Built with some assumptions

– Are considered good if they accurately predict

human behavior

Economic Models—2

• Ceteris paribus

– Latin: Means “other things being equal”

– Often used to build economic models

– Allows us to examine a change in one

variable while holding everything else

constant

Economic Analysis

• Endogenous factors

– Variables that are part of a model

• Exogenous factors

– Variables that cannot be accounted for in a

model

Models and Ceteris Paribus—1

• Who gets paid more…

– Educated or uneducated individuals?

– Skilled or unskilled labor?

– Worker right out of college or older worker?

– New employee or veteran employee?

– Safe or dangerous job?

– Particular ethnic groups?

– People in the country or city?

Models and Ceteris Paribus—1

• Who gets paid more…

– Educated or uneducated individuals?

– Skilled or unskilled labor?

– Worker right out of college or older worker?

– New employee or veteran employee?

– Safe or dangerous job?

– Particular ethnic groups?

– People in the country or city?

HOW CAN YOU KNOW FOR SURE?

PROVE IT

Models and Ceteris Paribus –

Small Group discussion

• Suppose you want to analyze wages and

are particularly interested in racism and

discrimination. How would you model

such a situation?

• What are the potential factors that might

confound you identifying the effect of

racism on wages?

• Does confounding mean we cannot

analyze the problem?

Graphs – 1 Plotting points

Graphs – 2 Slopes

Graphs 3 – Changing positive

slope

Graphs 4 – changing negative

slope

See K & W appendix to ch. 2

for much more practice with

graphs

Production

Human welfare can come from…

• Marketed material things (e.g. iPhones)

• Marketed services (e.g. a massage)

• Things not sold (e.g. clean air, hikes,

good social interactions

• The market economy (with other

institutions) facilitates production of some

of these goods and services, but not all

• All need to be produced by someone

What is needed for a restaurant

to produce a famous Spanish

food like gazpacho?

What is needed for a restaurant

to produce a famous Spanish

food like gazpacho?

You need factors of production

A key reason scarcity exists is the

factors of production are scarce

• Labor - skilled, unskilled and

entrepreneurial

• Land - all natural resources (owned

and not-owned)

• Capital - the "tools" of production -

machines, vehicles, buildings,

inventory, human capital

Human capital is especially

important for economic progress

What is the capital of the

following businesses?

•Machine shop

•Trucking firm

•Hotel

•Liquor store

•Accounting firm

How do the different factors

get paid?

• Labor - wages/salaries

• Capital - profits (businesses) or

higher wages (skills)

• Land – rents (always generated, but

not always owned by humans)

Tradeoffs

Production Possibilities Frontier— a

two-dimensional model of n-dimensional

economies • Production possibilities frontier

– Illustrates the combinations of outputs that a

society can produce if all of its resources are

being used efficiently

• Assumptions (ceteris paribus):

– Technology fixed

– Quantity of resources fixed

– Society produces only two goods (for

simplicity):

• Pizza and wings

Production Possibilities Frontier—2

• With regard to the PPF, an efficient

point is a point that is

A. impossible to reach.

B. inside the PPF.

C. outside the PPF.

D. on the PPF.

What do you think?

PPF and Opportunity Cost—1

• Why is the PPF downward-sloping?

– Must give up one good to increase production

of another

• Recall opportunity cost

– Highest-valued alternative given up to pursue

an action

• If we move down and to the right along

a PPF, the opportunity cost of this

movement can be measured in terms of

A. how much of the x-axis good we gain.

B. how much of the y-axis good we gain.

C. how much of the x-axis good we give up.

D. how much of the y-axis good we give up.

What do you think?

• BUT all resources are typically not perfectly

suited for producing both goods

• If true, the PPF will not have a constant

slope.

• AND the opportunity cost of producing a

good will rise as we produce more of it.

– i.e. the slope will get steeper as we move

from left to right.

PPF and Opportunity Cost—2

Small group discussions – Portland-

Area production tradeoffs – 5 minutes

• Willamette Valley is great at producing

wine and urban tourism. Name 8

resources that are critical to producing

each one?

• Can you tell stories where all of them

are used for only one good/service?

• “Law” of increasing opportunity cost

– The opportunity cost of producing a good

rises as society produces more of it.

– The PPF will not have a constant slope.

• The slope will rise (in absolute value) as we move

from left to right.

PPF and Opportunity Cost—3

PPF and Opportunity Cost—4

The PPF and Economic

Growth—1

• Economic growth

– The process that enables a society to produce

more output in the future

– Can be shown by a shift outward of the PPF

• Some previously unattainable good combinations

would now be possible to produce

The PPF and Economic

Growth—2

• The PPF could shift out because of

– New technology

– New (or better) resources available

• These changes in technology or resources

could affect the production of

– Only one good

– Both goods

Pizza-favoring Economic Growth—4

Shift in the PPF that increases

potential of both goods - 5

False.

It represents how

many cars and

bicycles are

produced, not

sold.

Bicycles

Cars

A

(True/False) Point A represents the amounts of

cars and bicycles that will be sold.

What do you think?

True.Bicycles

Cars

A

C

(True/False) Movement along the curve from point

A to point C shows us the opportunity cost of

producing more bicycles.

What do you think?

False.Bicycles

Cars

?

(True/False) If we have high unemployment,

then the curve shifts in.

What do you think?

True. Bicycles

Cars

(True/False) If an improved process for

manufacturing cars is introduced, society will be

able to produce more cars and more bicycles.

What do you think?

• Suppose there is high unemployment.

With respect to the PPF, what will

happen?

A. The PPF will shift inward.

B. The PPF will shift outward.

C. We will produce at a point inside the PPF.

D. We will produce at a point outside the

PPF.

What do you think?

Trade

The Circular Flow 1 —my

consumption is your income

The Circular Flow—2

• Barter

– Individuals trading a good or service in

exchange for something they want

• Double coincidence of wants

– Occurs when each party in an exchange

transaction has what the other person desires

The Circular Flow—3

Specialization and Trade—1

• Improvements in technology and

resources can make an economy more

productive.

• Specialization and trade can also create

gains for society.

• Specialization

– The limiting of one’s work to a particular area

• Assume now:

– Two goods (pizza and wings)

– Two people with different abilities in the

production of pizza and wings

Specialization and Trade—2

• Absolute advantage

– One person can perform one task more

effectively than the other person can.

– Who has the absolute advantage in pizza? In

wings?

Daily Production

Person Pizzas Wings

Debra Winger 60 120

Mike Piazza 24 72

Specialization and Trade—3

Specialization and Trade—4

Assume constant opportunity cost

(for simplicity)

Specialization and Trade—4

Assume constant opportunity cost

(for simplicity)

What does Debra give up to produce a pizza?

What does Mike give up to produce a pizza?

• Without specialization and trade:

– Mike and Debra each have to produce their own

wings and pizza

– Each person can only consume what they produce

Without Trade

Person Good Production Consumption

Debra Pizza 40 40

Wings 40 40

Mike Pizza 18 18

Wings 18 18

Specialization and Trade—5

• With specialization and trade:

– Debra produces pizza and gives 19 pizzas to Mike

– Mike produces wings and gives 47 wings to Debra

– Each person consumes more with trade

With Trade Gains from

Trade

Person Good Production Consumption

Debra Pizza 60 41 (keeps) + 1

Wings 0 47 (from Mike) + 7

Mike Pizza 0 19 (from Debra) + 1

Wings 72 25 (keeps) + 7

Specialization and Trade—6

Gains from Trade—1

Opportunity Cost

Person 1 Pizza 1 Wing

Debra Winger 2 wings

(120 ÷ 60)

1/2 pizzas

60 ÷ 120)

Mike Piazza 3 wings

(72 ÷ 24)

1/3 pizzas

(24 ÷ 72)

Daily Production

Person Pizzas Wings

Debra Winger 60 120

Mike Piazza 24 72

Gains from Trade—2

• Comparative advantage

– The ability to produce a good at a lower

opportunity cost

• Debra: pizza

• Mike: wings

Opportunity Cost

Person 1 Pizza 1 Wing

Debra Winger 2 wings

(120 ÷ 60)

1/2 pizzas

(60 ÷ 120)

Mike Piazza 3 wings

(72 ÷ 24)

1/3 pizzas

(24 ÷ 72)

Gains from Trade—3

Gains from Trade—4

• How did we know that Debra and Mike

would both be willing to trade 19 pizzas for

47 wings?

• Terms of trade

– The relative prices or exchange rate of goods

– We can express this as a ratio (Pizza:wings)

– For Debra, it is 1:2

– For Mike, it is 1:3

• As long as the terms of trade are between

the opportunity costs of the trading

partners, the trade benefits both sides.

Person Opportunity Cost Ratio

Debra Winger 1 pizza equals 2 wings 1:2 = 0.50

Terms of trade 19 pizzas for 47 wings 19:47 = 0.40

Mike Piazza 1 pizza equals 3 wings 1:3 = 0.33

Gains from Trade—5

• Cast Away (2000)

– Imagine a world in which there was no

specialization and trade.

• Your consumption = your production

• Could you do it?

Economics in Cast Away

Trade-off Between Present

and Future—1

• Short run

– The period in which we make decisions that

reflect our immediate or short-term wants, needs,

or limitations

• Consumers can only partially adjust behavior

• Long run

– The period in which we make decisions that

reflect our needs, wants, and limitations over a

long time horizon

• Consumers have time to fully adjust to market

conditions

• Consumer goods

– Goods produced for current

consumption

• Capital goods

– Goods that help produce other

valuable goods

• Investment

– Using resources to create or buy

new capital

Trade-off Between Present

and Future—2

Capital Goods and Future

Growth—1

Capital Goods and Future

Growth—2

Visualizing Investment—1

• Suppose that instead of producing

pizza, we spent resources in order to

improve pizza-making technology.

• What happens…

– Today?

– Tomorrow?

No InvestmentTime Period

1

2

3

4

Investment in

Capital Goods

Visualizing Investment—2

• Other examples of long-term investment:

Visualizing Investment—3

• What is the opportunity cost of

producing capital goods instead of

consumer goods?

A. We give up consumption today.

B. We give up consumption tomorrow.

C. We have less employment today.

D. We have a lower standard of living

tomorrow.

What do you think?

Conclusions

• Economists use models to understand how the

economy works.

• The production possibilities frontier (PPF)

illustrates the benefits of trade and allows us to

describe ways to grow the economy.

• When producers specialize, they focus on those

goods and services for which they have the

lowest opportunity cost and trade with others

who are good at making something else.